The London Inter-Bank Offered Rate, popularly known as LIBOR is the benchmark rate which the banks charge each other for short term loans. It is also known as ICE LIBOR or Intercontinental Exchange LIBOR. In other words, it is the average of the interest rates estimated by each of the leading and most prominent banks in London that according to them would be charged from them if they borrow from other banks. It is considered to be the primary benchmark or standard for short term rates of interest round the world.
The rate is administered by the IBA i.e. ICE Benchmark Administration. It is based upon 5 different currencies being - the US Dollar (USD), UK Pound (GBP), Japanese Yen (JPY), Euro (EUR) and Swiss Franc (CHF). The LIBOR interest rate serves seven different maturities: overnight, one week, and 1, 2, 3, 6 & 12 months. There are a total of 35 different LIBOR rates for each business day. The most commonly quoted rate is the three-month US dollar rate (usually referred to as the “current LIBOR rate”).
LIBOR Rate History
In 1984, it became clearly visible that a large number of banks were actively dealing in a large variety of new market instruments. Recognizing the fact that such tools and instruments meant a rise in business in the inter-bank market, it was realised that there is a need of measure of uniformity for continuous growth. In October, 1984 the British Banker’s Association (BBA) - working with other parties formed the BBAIRS terms. The successor of BBAIRS became BBA LIBOR in 1986.
Importance of LIBOR
The LIBOR interest rate is one of the most globally significant numbers in finance. Banks, financial institutions, and credit agencies round the world look up to LIBOR rates to set their own interest rates. Hence LIBOR is taken as the benchmark rate. According to the United Kingdom Treasury, the value of financial contracts tied to LIBOR touches about $300 trillion (consumer loans not included).
One of the main reasons LIBOR is used so widely is because of the way the rate is calculated and constructed every day which makes it updated and useful. Also, LIBOR represents the lowest borrowing rate among banks and big financial institutions. Other rates being calculated by taking LIBOR as the base are calculated as LIBOR + X bps (basis points). If the base (LIBOR) is affected it will affect all the other rates.
LIBOR is commonly used as the floating rate for interest rate swaps, future contracts, mortgages, student loans, and corporate funding. It is also used for setting the settlement prices for interest rate future contracts that help companies to hedge interest rate exposure.
LIBOR interest rates provide a fair idea to central banks and other important institutions about the expectations on interest rates and linked developments.
Components of LIBOR
LIBOR is made up of 2 components: rate and credit, which majorly affect its movement. The rate is the "risk free" Time Value of Money and credit measures the Default Risk (risk of not being paid back). Both of these elements can drive LIBOR up or down.
Factors Affecting LIBOR
Since LIBOR is an interest rate, it is affected by all the general factors that affect any other interest rate. Some of the major ones being monetary policy of an economy, the rate of growth of an economy, the level of inflation that prevails, global liquidity and uncertainty about future economic growth.
How LIBOR Affects Other Currencies
LIBOR being an interest rate derived from the rates suggested by various premier London banks affects various currencies which in turn affect each other leading to a cycle of effects. The change in LIBOR leads to a change in the interest rates of various currencies which make some economies more profitable or safe to invest in terms of equities of debt as compared to others. The shift in investments from one economy to other depending upon the interest rate, further leads to fluctuations in the value of currencies of these economies.
Calculation of LIBOR
LIBOR is produced once a day by the Intercontinental Exchange (ICE) and is regulated by the Financial Conduct Authority. A total of 35 LIBOR rates are calculated and posted each day.
Every day, before 11 am (GMT), the ICE Benchmark Administration (IBA) asks the panel of contributor banks (which are large banks having significant presence in the London market and are members of ICE LIBOR panel) to answer the following question:
“At what rate could you borrow funds, were you to do so by asking for and then accepting interbank offers in a reasonable market size just prior to 11 a.m. London time?"
The banks then confidentially send their answers for each of the loan maturities, ranging from overnight to one year – annualized interest rates for unsecured funding for a specified period and specified currency.
The IBA calculates the LIBOR rate using a trimmed mean, throwing out the highest 4 and lowest 4 figures and averaging the remaining numbers.
The LIBOR rates are published by the market intelligence firm Thomson Reuters around 11:45 am (GMT) each day.
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